ChainWhat it assumes · how to break it
Start
World oil prices rise sharply, as when energy prices surged in 2022 after Russia's invasion of Ukraine.
1
As a result, firms' costs of production rise, because oil is an input into fuel, transport, plastics, chemicals and much electricity generation.
costs of production · raw materials
costs of production · raw materials
Assumes: Oil is a significant input for most firms.
But: Service-sector firms such as banks and software companies use little oil directly, so their costs rise much less than those of airlines or hauliers.
2
This means the short-run aggregate supply curve shifts to the left, as firms need higher prices to supply the same output.
short-run aggregate supply (SRAS)
short-run aggregate supply (SRAS)
Assumes: Firms pass the higher costs on in prices.
But: Firms facing strong competition or price-elastic demand may absorb part of the rise in their profit margins.
3
Consequently, real output falls along the AD curve while the price level rises, a combination known as stagflation.
stagflation
stagflation
Assumes: AD is unchanged when SRAS shifts.
But: If the government or central bank responds by boosting AD, output may hold up, though inflation is then higher still.
4
At the same time, households' real incomes fall, because they must spend more on petrol and heating, which have price inelastic demand, leaving less to spend on other goods and services.
real income · price inelastic demand
real income · price inelastic demand
Best link to attack
Assumes: Households cannot quickly cut their energy use.
Assumes: Households cannot quickly cut their energy use.
But: Households with savings may run them down to maintain spending, and government support with energy bills, as in 2022, protects real incomes.
5
Therefore, consumption on other goods falls, so AD shifts left as well, and real GDP growth slows further or turns negative.
consumption · aggregate demand
consumption · aggregate demand
Assumes: The fall in spending is not offset elsewhere.
But: Oil-exporting countries earn more and may spend some of it on imports, including UK exports, which supports AD.
End
Economic growth slows, and the economy may enter recession while inflation is rising.
Evaluation chain
- E1However, the squeeze on consumption depends on households being unable to protect their real incomes from higher energy bills.
- E2When the government caps energy prices or gives households support payments, as the UK did in 2022, then the rise in energy bills that households actually face is smaller.
- E3As a result, real incomes fall less and consumption on other goods holds up, so AD falls much less, although government borrowing rises.
- E4So growth slows by less than the size of the oil shock suggests, and the cost is moved onto the government's budget instead.
Another way to attack it: The effect depends on whether the economy is an oil exporter or importer: a net exporter gains income and tax revenue from the higher price. It also depends on how long the rise lasts, since a short spike does far less damage than a sustained rise.
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Questions this answers
- Assess the impact of a rise in world oil prices on economic growth in an oil-importing country.
- Explain, using an AD/AS diagram, how an oil price shock can cause stagflation.
- Evaluate the likely effects of higher energy prices on UK real GDP.
Diagram
AD/AS diagram: SRAS shifts left (price level up, real output down); then show AD shifting left as real incomes are squeezed, reducing real output further.
Reverse and related
Fall in world oil prices → costs fall, SRAS shifts right and real incomes rise, boosting consumption and growth.